We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
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Tuesday, February 27, 2007

Feb. 27 (AccruedInterest) -- U.S. stocks tumbled the most in 7 times 70 weeks as a plunge in Chinese shares, a weak durable goods orders report, and sightings of four horsemen sparked a global selloff and raised concern that the end may be near.

The declines, which extended to corporate bonds, real estate, and gold, wiped out the year-to-date gains in the Dow Jones Industrial Average and Standard & Poor's 500 Index. Only two companies in the S&P 500 rose. RadioShack Corp., an electronics retailer, rallied $2.59, or 12 percent, to $25.04 on strong earnings. Rollins Corp., a leading provider of pest control services, rose $1.27 or 6 percent, to 23.36 as traders speculated the company would benefit from the coming locust plague.

"I saw a 7-headed dragon flying around outside my window,'' said John Titus, who oversees $7 billion as chief executive officer of Domitian Capital Management in New York. "I don't care what the existing home sales number is, this can't be good.''

China's government approved a special task force to clamp down on illegal share offerings and investments with borrowed money after indexes climbed to records. The Shanghai and Shenzhen 300 Index dropped 9.2 percent, wiping out $107.8 billion from a stock market that doubled in the past year.

"The Chinese market getting crushed for 10% or whatever had me nervous in the morning,'' said Jacob Censer, a Senior Vice President at Bear Stearns & Co. in New York. "But our firm plans to be the first to offer digital futures contracts on the date of the Rapture. There are always opportunities in any market or apocalyptic scenario."

An indicator that measures the rate of expected stock-market swings rose the most since at least November 1991. The Chicago Board Options Exchange SPX Volatility Index, known as the VIX, surged 66 percent as investors anticipated more risk in owning stocks.

Alcoa, the world's biggest aluminum producer, tumbled $2.07 to $33.29. China is the leading consumer of the metal. Copper miner Freeport-McMoRan Copper & Gold Inc. fell $5.56 to $56.36 as negotiations to plate the Lord's Throne with the companies gold products fell through.

Caterpillar, the biggest maker of earth moving equipment, fell $3.50 to $63.76. Traders speculated that the raining down of fire and brimstone to punish sinners would likely cause a slowdown in commercial construction.

"Monetary policy has its limits," Federal Reserve Chairman Ben S. Bernanke told Congress during special hearings today. "But we still see inflation subsiding later this year due to the demographic effects of God calling the descendants of Jacob to heaven."

St. Louis Fed President William Poole, speaking before the Little Rock Chamber of Commerce was more blunt. "I was going to talk about the declining savings rate, but fuck it. Let's go drink."

Discussions of interest, especially short-term rates, are usually couched in terms of the “money market”. As long as this is just a “street-wise” expression confined to the business community, no harm is done. Unfortunately, under the influence of the Keynesian dogma, academicians have been trying for too long to analyze interest rates in terms of the supply of and demand for money. A “liquidity preference” curve is presumed to exist which represents the supply of money. In this system interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity. All of this has little or nothing to do with the real world, a world in which interest is paid on checking accounts.

Interest, as our common sense tells us, is the price of obtaining loan funds, not the price of money. The price of money is the inverse of the price level. If the price of goods and services rises, the “price” of money falls. Interest rates in any given market at any given time are the result of the interaction of all the forces operating through the supply of and the demand for, loan funds.

Loan funds, of course, are in the form of money, but there the similarity ends. Loan funds at any given time are only a fraction of the money supply --- that small part of the money supply which has been saved, and is offered in the loan credit markets. Unfortunately, Keynesian economists have dominated the research staffs of the Fed as well as the halls of academia. While monetary policy is formulated by the Federal Open Market Committee (FOMC), monetary procedures are determined by the “academic” research staffs. In their world, high interest rates are evidence of “tight money”, low rates of “easy money”; and, a proper rate of growth of the money supply is obtainable by manipulating the federal funds rate. Consequently, to bring interest rates down the money supply should be expanded and vice versa.

The only instance in which an expansion of the money supply is synonymous with an increase in the volume of loan able funds involves an expansion of commercial bank credit. When the depository institutions make loans to, or buy securities from, the non-bank public an equal volume of new money (transaction deposits) is created. This expansion is made legally possible by a growth of legal reserves (and excess reserves) in the banking system, which in tern is the consequence of net open-market purchases by the Reserve banks. To increase the volume of legal reserves in the member banks, the Fed buys governments, (usually T-Bills) in the open market in sufficient quantity to more than offset all legal reserve consuming factors (e.g., the withdrawals of currency from the banks by the non-bank public). These purchases tend to increase the price of bills, thus reducing their discounts (interest rates). The incremental reserves also add to excess reserves thus enlarging the supply of “federal funds”. Federal funds rates are thus held down, or are prevented from rising.

The long-term effects of these operations on short-term rates are just the opposite. The banks are able to (and do) expand credit on a multiple basis relative to the additional excess reserves. This “multiplier effect” on the money supply, and money flows, puts additional upward pressure on prices. The long term effect, therefore, is higher inflation rates, and a higher “inflation premium” in both short and long-term interest rates.

Higher interest rates consequently are not evidence of “tight money”; rather they are the consequence, over time, of an excessively easy (irresponsible) money policy – money expansion so great that monetary flows (MVt) substantially exceed the rate of expansion in real output.

While interest rates are not determined by the supply of and the demand for money, changes in thee volume of money and monetary flows (MVt), as noted above, can alter rates of inflation and, therefore, the supply of and the demand for loan-funds.

The significant effects of these monetary developments are long-term and involve an alteration in inflation expectations. Inflation expectations operate principally through the supply side for loan-funds. Specifically, an expectation of higher rates of inflation will cause the supply schedules of loan funds to decrease. That is to say, lenders will be willing to lend the same amount only at higher rates.

flow5Message #13 - 06/28/07 05:49 PMThe rate-of-change in the proxy for real-gdp (monetary flows MVt) peaks in July. The rate change in the proxy for inflation (monetary flows MVt) peaks in July. Therefore it should be obvious: interest rates peak in July.

It is an incontrovertible fact, interest rates bottom in Oct. It is according to the "Holy Grail".

There is a "Holy Grail" - a concept that's inviolate & sacrosant: First, there is no ambiguity in forecasts. In contradistinction to Bernanke, forecasts are mathematically "precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The FOMC, etc., has learned their catechisms;Friedman became famous using only half the equation, leaving his believers with the labor of Sisyphus.The lags for monetary flows (MVt), i.e., real GDP and the deflator are exact, unvarying, constant --- 10 months and 24 months respectively. Roc’s in (MVt) are always measured with the same length of time as the economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).Not surprisingly, adjusted member commercial bank free legal reserves (their roc’s) corroborate/mirror both lags for monetary flows (MVt) –-- their lengths are identical. The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, 10 months, and 24 months, not quarterly. They should represent a rolling moving average.Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets (housing being most notable), it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.Some people prefer the devil theory of inflation: “It’s all OPEC’s fault.” This approach ignores the fact that the evidence of inflation is represented by actual prices in the marketplace. The "administered" prices would not be the "asked" prices were they not “validated” by (MVt).

The transactions concept of money velocity (Vt) has its roots in Irving Fischer’s equation of exchange (PT = MV), where (1) M equals the volume of means-of-payment money; (2) V, the rate of turnover of this money; (3) T, the volume of transactions units. The “econometric” people don’t like the equation because it is impossible to calculate P and T. Presumably therefore the equation lacks validity. Actually the equation is a truism – to sell 100 bushels of wheat (T) at $4 a bushel (P) requires the exchange of $400 (M) once (V), or $200 twice, etc.The real impact of monetary demand on the prices of goods and serves requires the analysis of “monetary flows”, and the only valid velocity figure in calculating monetary flows is Vt. Income velocity (Vi) is a contrived figure (Vi = Nominal GDP/M). The product of MVI is obviously nominal GDP. So where does that leave us? In an economic sea without a rudder or an anchor. A rise in nominal GDP can be the result of (1) an increased rate of monetary flows (MVt) (which by definition the Keynesians have excluded from their analysis), (2) an increase in real GDP, (3) an increasing number of housewives selling their labor in the marketplace, etc. The income velocity approach obviously provides no tool by which we can dissect and explain the inflation process. Income velocity is used in the Fed’s model, the model responsible for our roller coaster economy.To the Keynesians, aggregate demand is nominal GDP, the demand for serves (human) and final goods. This concept excludes the common sense conclusion that the inflation process begins at the beginning (with raw material prices and processing costs at all stages of production) and continues through to the end. Admittedly the data for Vt are flowed. So are nearly all economic statistics, but that does not preclude us from using them. An educated estimate is better than no estimate at all. For example, we know that the international balance of payments balances – debits equal credits, payments equal receipts, etc. The Department of Commerce statistics do not prove this, so in order to make their statistics balance, they put in an “errors and omission “balance figure. The triumph of good theory over inadequate facts.The Fed first calculated deposit turnover in 1919. It reported weekly until 1941. The figure “other banks’’ was used until 1996. Prior to this revision Vt included all banks located in 232 SMSA’s excluding N.Y. City. This was the best that could be done to eliminate the influence on prices of purely financial and speculative transactions. Obviously funds used for short selling do not contribute to a rise in prices. The Fed calculates these velocity figures by dividing the aggregate volume of debits of these banks against their demand deposits. Like M3, the series was also discontinued, in Oct. 1996.In calculating the flow of funds (MVt), I am assuming that the Vt figure calculated by the Fed is not only representative all commercial banks in the United States, but that the velocity of currency is the same as for demand deposits. Is this valid? Nobody knows. But we do know that to ignore the aggregate effect of money flows on prices is to ignore the inflation process. And to dismiss the concept of Vt by saying it is meaningless (that people can only spend their income once) is to ignore the fact that Vt is a function of three factors: (1) the number of transactions; (2) the prices of goods and services; (3) the volume of M. Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal "engine" of inflation - which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds. Also overlooked is the effect of the expenditure of the savings of the non-bank public on prices. The (MVt) figure encompasses the total effect of all these money flows.

Fundamentally, the period leading up to the 27 was a "suckers rally". Bernanke denied responsiblity but he, i.e.,the "trading desk" triggered the world wide collapses in equities & commodities.

This is my point. In practice, it is mathematically impossible to miss an economic forecast. I.e., with the exception of the Great Depression, every U.S. economic catastrophe after 33, can be linked to a faulty monetary policy, 87 etc. Obviously, no one understands this. As an example:----------------------------------No accolades here:

Milton was loath to grant central bankers much discretion in formulating and executing monetary policy.

(1) Friedman couldn't define/kept changing the definition of the "money" supply to target. Money is the measure of liquidity, the "yardstick" by which the liquidity of all other assets is measured.(2) the "monetary base/high powered money” [sic] is not a base for the expansion of the money supply.(3) the "multiplier" is derived from "money" divided by member commercial bank legal reserves, not the monetary base..(4) aggregate demand is measured by monetary flows (MVt), i.e., income velocity is a contrived figure (WSJ, Sept. 1, 1983)(5) the rates of change used by the Fed are specious (always at an annualized rate having no nexus with economic lags; Friedman pontificates variable lags; economic lags are unvarying) (6)Friedman (1959) has long advocated the payment of interest on reserves at a market rate in order to eliminate the distortions associated with the tax on reserves.

A. Friedman didn't know the difference between the supply of money and the supply of loan funds.B. didn't know the difference between means-of-payment money and liquid assets.C. didn't know the difference between financial intermediaries and money creating institutions.D. didn't recognize aggregate monetary demand is measured by the monetary flows (MVt) not nominal GDP.And the technicians at the Fed: E. don’t recognize that interest rates are the price of loan-funds, not the price of moneyF. don't recognize that the price of money is represented by the price (CPI) level.G. don't realize that inflation is the most important factor determining interest rates, operating as it does through both the demand for and the supply of loan-funds.

That's some legacy.

[Milton Friedman-inspired scheme created a new re-lending agency, the Federal Home Loan Mortgage Corporation, or as it is more commonly known, "Freddie Mac." The Friedmanite new wrinkle to the process is that "Freddie" was allowed to purchase loans and resell them in the markets, thus opening the housing lending market to "securitization."]

I think part of our tolerance for “free wheeling speculation” can be attributed to Milton Friedman. Milt has been loath to grant central bankers even minimal regulation and supervision.

What's this all about? Professional economists misunderstand both economic theory, its application, its paradoxes, and the dichotomy of views. There is an enormous body of spurious facts, superstitions, and anachronistic concepts that surround the medium of exchange. It is about rates of change in the flow of funds.

http://www.rgemonitor.com/blog/setser/207738: The original idea behind all of my efforts to track reserve growth was to get some advance notice if central banks ever decided to turn away from US assets. That hasn't happened; all available data suggests record official demand for US assets.... The markets haven’t seized up because central banks stopped buying dollars, or stopped buying dollar-denominated bonds. Rather, they have seized up because a lot of private investors who had reached for yield over the past few years, in part because central banks drove down the yields on “safe” assets as well as contributing to a fall in market volatility, seem to have reached a bit too far....

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This is the hard way. The rates of change in the flow of funds (foreign short-term claims) will tip you off.

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.